Borrow, contribute or a bit both ways?

With a further reduction in superannuation contributions caps handed down in the 2016 federal budget, Tim Miller assesses whether gearing strategies may now become more attractive.

Will limited recourse borrowing arrangements (LRBA), and in particular related-party LRBAs, become the preferred strategy for SMSF investors looking to increase the value of their fund balance rather than making non-concessional contributions? It’s a stretch to suggest this will become a mainstream strategy, but it will certainly be a consideration for those who are some way from retirement and looking at ways to accumulate money for retirement without locking contributions away, given the lack of confidence the superannuation system provides many investors.


From a strategic point of view there is certainly an opportunity for those investors who have the capacity to make contributions, but don’t want to commit significant amounts to the preservation nature of superannuation. Given all contributions are preserved until a condition of release is satisfied, there is clearly a reluctance for those who have entered the workforce, and still have potentially 30 to 40 years ahead of them until they can access their money, to invest their surplus funds into a vehicle that has the potential of imposing severe penalties for accessing that money early. However, given the chance to lend money to an SMSF where you can effectively call on that money at any stage in the life cycle of the transaction may be more appealing. We will look at the recourse nature, or more appropriately the liquidity nature, further below.

Cost prohibitive
One element any client would need to take into consideration is the cost associated with establishing an LRBA arrangement. In 2007, when the instalment warrant legislation was introduced allowing SMSFs to borrow to acquire an asset, it was not unheard of for document providers to charge up to $10,000 to establish a borrowing arrangement, although it was more common to see fees between $2000 and $3000 being imposed.

Usually this incorporated a deed upgrade as most trust deeds at the time did not provide the ability for a fund to borrow. These days, on the assumption most trust deeds are written to incorporate the appropriate borrowing clauses, you are able to obtain borrowing documentation for as little as a couple of hundred dollars. Of course, depending on how much work clients ask others to do will always determine the total costs associated with the transaction, but it is certainly not as cost prohibitive as it once was.

Holding trustee

Likewise having the ability to use the same holding trustee will mean there is an initial cost upfront to establish that holding trustee company. Let’s assume we all agree it is best, although not required, to use a company structure for this purpose. But once in place the cost becomes increasingly insignificant, particularly if multiple arrangements are put in place.It should be noted as part of the above disclaimer about using a corporate holding trustee versus individual trustees that SMSF trustees are still required to keep all SMSF assets separate from personal assets under the trustee covenants and, importantly, the operating standards, so despite the fund not transferring ownership until the liability is paid off, if ever, it is best to assume complete separation of these assets for identification purposes. In cases involving bankruptcy I’ve seen the bankruptcy administrator try to claim the asset held in the individual’s name as holding trustee for the SMSF as the owner of the asset for bankruptcy purposes.

PCG 2016/5 and TD 2016/16

The ATO has in recent times released practical compliance guidelines (PCG) and a taxation determination (TD), both identified by the number above, to address the issue of ensuring any related-party LRBA is established and maintained on an arm’s-length basis. These documents, primarily PCG 2016/5, identify the safe harbour rules the ATO deems appropriate to satisfy an arm’s-length transaction therefore ensuring the income attributable to any LRBA asset is taxed at the concessional superannuation tax rate. TD 2016/16 is effectively a consolidation of interpretive decisions (ID) ATO ID 2015/27 and ATO ID 2015/28, which themselves are updates of ATO ID 2014/39 and ATO ID 2014/40. This newly released determination uses the safe harbour rules provided by the ATO to highlight how non-arm’s-length income can be avoided.Of course, these ATO guidelines are exactly that and there is nothing preventing an SMSF trustee from creating terms they determine to be on an arm’s-length basis, perhaps as a result of seeking out a loan from a commercial provider and replicating them. It will then be incumbent on the trustee to justify to the ATO that the loan is arm’s length in the event the regulator reviews the arrangement.

Application of safe harbour rules – listed securities

Let’s consider what a related-party LRBA arrangement might look like using the example of listed shares. The ATO safe harbour rules provide the ability to lend up to 50 per cent for a period of seven years. The guidelines also propose an interest rate based on the Reserve Bank of Australia (RBA) Indicator Lending Rates for banks providing standard variable housing loans for investors plus 2 per cent, using the rate indicated for May prior to the financial year the loan is entered into. The May 2016 rate was 5.65 per cent, meaning the appropriate rate for a loan entered into for 2016/17 is 7.65 per cent.If we assume a concessional contribution cap of $30,000 for the 2017 financial year, this provides a single member fund with the ability to acquire parcels of shares to the value of $60,000, effectively doubling a fund’s holdings in any given security. With a doubling of the number of shares a fund can obtain, the dividend the fund will receive also doubles. This would mean the fund is likely to look at investing in shares with an annual dividend yield of at least 4 per cent to cover the interest payments. Given the safe harbour rules require principal and interest payments monthly, a fund would require upfront liquidity to meet its payment obligations in between dividends and would likely seek out slightly higher yields to cover principal payments. The Australian share market may not be generating the returns at the present time to warrant jumping on board immediately, however, a quick scan of the largest 150 companies on the Australian Securities Exchange shows 45 companies are paying annual yields in excess of 5 per cent as of October 2016. Regardless, it’s certainly not unrealistic to suggest a fund can use this strategy to its advantage while there is ongoing uncertainty about how much money you can put into superannuation, or indeed a lack of desire to preserve contributions.

The benefit, of course, particularly with regards to listed shares is the liquid nature of the transaction. If the SMSF trustees or members feel they don’t want to continue with the transaction, the LRBA accommodates this by allowing the parcel of shares to be sold and the loan repaid to the lender. In the meantime they have received the deduction on the contribution in the first instance, assuming a self-employed contribution has been made as part of the transaction, and who knows, perhaps they have made some gains along the way, which, of course, will be retained in the fund over and above the liability to pay out the loan.

Property transactions

Using this strategy for property is going to be more restrictive due to the general valuation issues associated with property and the capital requirements for the fund, and specifically the lack of liquidity associated with property transactions versus shares. But it still may provide an opportunity for those who have accumulated a reasonable balance and have the capacity to make some contributions without using the entirety of their non-concessional cap.Given the recent updated announcement from the government to replace the lifetime non-concessional contributions cap of $500,000 with a reduced annual limit of $100,000, it may be particularly beneficial if an individual has access to sufficient funds to contribute any amount up to the existing bring-forward amount of $540,000 in 2016/17. Based on the government’s announcement, the $540,000 can be used this year, but anyone who hasn’t used it entirely by 30 June 2017 will revert to a transitional amount incorporating $180,000 this year and $100,000 for each of the next two years.

As defined by the safe harbour guidelines, the loan-to-value ratio requirement for property is 70 per cent regardless of whether the property is commercial or residential, and the interest rate, as per with listed securities, is based on the RBA Indicator Lending Rates for banks providing standard variable housing loans for investors as at May preceding the relevant financial year. So for 2016/17, the applicable interest rate is 5.65 per cent per year.

At the extreme level of this example, an SMSF with $230,000 could acquire a $770,000 property via a $540,000 related-party loan, rather than a contribution. The yield would obviously be determined by the nature of the property, that is, whether it is a residential investment property or a commercial property with commercial likely to provide the higher yield. But for a small business operator looking for a business premises where their rental payments are in effect contributing towards the ongoing acquisition of the property, rather than going into someone else’s pocket, this could be a viable strategy. As stated above, these numbers are at the extreme end of the lowest balance versus highest contribution level, but variations of this strategy could suit a substantial number of SMSF trustees who are also small business operators and have wealth external to superannuation.

Superannuation strategies beyond 2017

We are no doubt entering a period where the validity of superannuation, and particularly SMSFs, will be brought into question by the naysayers and alarmists, which in reality has been happening since their introduction in 1999 and previously as excluded funds. While the strategy won’t be for everyone, we have to look for opportunities that identify why superannuation is an effective investment and retirement vehicle, particularly for those who are not engaged with it as yet, and this may be one of those avenues.If $1.6 million is to become a reality and subsequently a goal, then we have to look at ways to achieve that goal. With a strategy such as this, you must highlight there are costs associated with it, primarily being establishment, administration and taxation costs, but also how those costs measure up in relation to trying to accumulate wealth outside of super with the associated personal tax liabilities and a goal to contribute in the future.

Of course, this strategy highlights the use of LRBAs with related-party loans in accordance with the ATO safe harbour guidelines. It hasn’t given consideration to the use of unit trusts or other structures, such as private companies, as neither of these are contemplated by the ATO, but both are accessible for SMSFs so long as the trustees are mindful of the in-house asset restrictions and exceptions.

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